The Bank of England's decision to hike interest rates for the first time in a decade has sent reverberations across the financial industry - not least the bond market.

Bonds play a crucial role in the theory behind investment portfolios and are treated as the lower risk element within them.

But almost a decade of super-low interest rates and quantitative easing has sent bond prices soaring since the financial crisis - and led to countless warnings that they are now a far riskier proposition.

Now with interest rates heading up, the environment has got a whole lot tougher for both government and corporate bonds.

The Bank of England's Monetary Policy Committee voted 7-2 in favour of increasing the base rates by 0.25 per cent to 0.50 per cent on Thursday

Bond prices and the income they pay out, known as their yield, move in opposite directions. When prices are high, yields are low.

As the financial crisis hit, central banks around the world, such as the Bank of England attempted to pump money into the system and pull down the cost of government debt with quantitative easing, which involved buying large numbers of bonds.

This along with slashing interest rates to record low levels pulled down the return offered by new bonds and drove the price up of existing bonds traded second hand, dragging down their yields.

Share this article

HOW THIS IS MONEY CAN HELP

Top grade government bonds are considered the safest investments around and in the flight to safety following the financial crisis more investors rushed to buy - and were willing to accept lower yields to put their money in a safe place.

All of these factors combined meant that yields on government bonds around the world hit record low levels, some have even traded second-hand with negative yields.

The concern is that with quantitative easing coming to an end and interest rates moving up, investors will shun the low yields on bonds, their value could dip and these supposedly safe investments could be volatile.

Selling, and selling fast might seem like the logical thing to do here, but it's not always.

It is important to consider the role of bonds within a portfolio and determine whether they are still worth holding onto even if their value has taken a hit.

What are bonds?

Bonds are a form of IOU. Typically, a bond involves investors lending money to governments or companies in return for a set rate of interest and their money back at the end of the bond's term.

This set interest payment is known as the coupon. A bond’s yield is the annual investment return as a percentage of the price it was bought for.

A bond bought when it is issued will pay out its listed rate of return, for example a £100 ten-year government bond at 2 per cent would pay £2 per year. It will then return the £100 sum invested at the end of its life, known as maturity.

If you buy that bond second hand it still pays out the same coupon, however, the yield that you get depends on the price you paid for it.

For example, if you paid £105, you get a yield of 1.9 per cent (£2 as a percentage of £105) and will only get the bond's original £100 back at the end.

This is why bond investors talk about a yield to maturity.

Why bonds?

The art of investing is all about mixing assets to build a portfolio aligned to your investment outlook and attitude to risk - with shares and bonds as primary components.

The former, also known as equities, are typically considered as the asset that drives growth in your portfolio, while bonds are there to serve as the security anchor and provide income - the safest of which are considered to be government bonds.

The other low risk alternative is holding cash.

Government bonds, called gilts in the UK, with a, say, 1 per cent coupon look less attractive now compered to cash with the base rate at 0.5 per cent than when it was at a rock- bottom low of 0.25 per cent.

High quality corporate bonds, which also tend to have a modest coupon, are likely to suffer as well.

This is bad news for investors and some experts have predicted a bond sell off for this reason.

The basic economics of investment bonds tell us this would likely result in a fall in the prices of such products.

Bonds with longer maturity are likely to experience even more drastic price reductions because they face inflation and interest rate risks over longer periods of time.

Any falls in bond prices will drive up yields, which is bad news for sellers, but could present a good buy opportunity - especially if the yield reverts to where it was previously.

It seems that many investors were tempted to try some such trading, as the UK Government bond market rallied 5 per cent in the hours after the rate hike announcement.

Different types of bond

There are a multitude of bonds to choose from and each offers different levels of risk and reward: junk bonds are usually cheap and offer high returns on the basis their probability of default is higher than AAA-rated corporate bonds which are often seen as a fairly 'safe' bet.

Governments also issue bonds - in the UK they are referred to as gilts and in the US as treasuries.

If it looks like a country may default on its debts, the price of its bonds plummets and the yield rises as investors demand a higher return to lend it money. This happened with crisis during the eurozone debt crisis.

The safest bonds are considered to be from countries with top-rated finances - and investors are advised to seek out those in their own currency, to minimise risk from foreign exchange movements.

Where the government bond is issued on behalf of a country with its own currency and central bank and has coupons paid in its own currency, it's less likely that a situation such as that seen in Greece will arise.

This is because central banks can create their own money to pay the interest it owes to investors on bonds.

Longer dated bonds are considered to be at a greater risk from interest rates rising faster than expected than shorter ones, as what happens in the near future is more easily predictable.

What should bond investors do now?

It is important to consider your position before shedding your bond positions. In truth, bond yields have risen in the last three months as the market anticipated, or priced-in, the rise.

If the domestic landscape for investment bonds appears too uncertain, it might be worth looking for opportunities overseas.

Laith Khalaf, senior analyst at Hargreaves Lansdown, recommends combing through your portfolio invested in bonds that may have got out of kilter following the rate rise.

It is possible to hold individual bonds, but you will need to build a portfolio yourself. The alternative is to invest in a bond fund.

Rather than holding individual fixed-rate bonds, consider holding them in strategic bond funds, where a fund manager has the freedom to invest across the bond spectrum to seek opportunities, and also to protect investors if there is a sell-off, he says.

Those saving into pensions might have to do more tinkering with their portfolio - depending on how long they have to go before retirement. Many pension schemes typically increase the allocation of their member's cash into bond funds as they approach retirement by default. You can find out more about this here.

It is important to consider the role of bonds within a portfolio and determine whether they are still worth holding onto even if their value has taken a hit

Paul Angell, an analyst at Square Mile Investment Consulting and Research, said the rate rise should does not dilute the diversification benefits that bonds provide to investment portfolios.

He added investors concerned about interest rate risk in lower-yielding bonds probably reduce their bond exposures some time ago.

'Valuations across asset classes are high,' Angell said.

'However, so is the opportunity cost of holding cash. Where possible, we prefer low- risk bond funds, that invest in high-quality, short-dated corporate bonds, to cash for their admittedly small income payments.'

What bond fund managers are doing

Bryn Jones, manager of Rathbone Strategic Bond Fund, said he has been wary of government bonds for some time because they are particularly sensitive to interest rate movement - particularly those with long life spans.

That said, he sold a four-year gilt, added a small amount of longer-dated gilts to the portfolio and bought some inflation-linked gilts that mature in eight years, last week, prior to the rate rise, after the 10-year gilt yield rose above 1.40 per cent.

Jones said he has no plans on buying or selling bonds in direct response of the rise in interest rates.

His confidence in bonds stems from sentiments from Mark Carney, Governor of the BoE, shortly after the Monetary Policy Committee voted 7-2 in favour of increasing the base rate.

Carney said he expected inflation to shrink back to the Bank of England's 2 per cent target and indicated that only two more rate rises of 0.25 per cent could occur over the next three years.

'We’re happy owners of gilts at the moment,' Jones said.

'We believe this is a one-off calibration by the Bank of England and it’s unlikely to add another 0.25 per cent rise until next year,' he said.

'The Bank was cautious immediately following the Brexit referendum vote, dramatically loosening monetary policy in a bid to stave off a drop in GDP growth.

'At the time, we felt this was akin to using a sledge hammer to crack a nut, and perhaps the 0.25 per cent increase is the Bank coming round to that way of thinking.'

Richard Hodges, fund manager and head of unconstrained fixed income at Nomura Asset Management, said his exposure to long term UK government yields was minimal but expressed through an allocation to UK inflation-linked government securities.

He added: 'The effects of the rate rise will be marginal, but positive. We have no plan to make any significant changes in our exposure to gilts or other long term UK interest rate sensitive bonds.'

Five bond funds to protect against rising rate

Bonds are complex, so unless you have extensive knowledge in the area, it is best to outsource things to a fund manager who earns their corn by choosing an array of quality, high-yield and government bonds for the best returns.

Angell has suggested four funds for income-hungry investors who would rather not cherry-pick their own stocks.

Paul Angell said investors should remember the diversification benefits that bonds provide to investment portfolios

AXA Sterling Credit Short Duration Bond: Managed by Nicolas Trindade, the fund aims to provide income combined with any capital growth through investment in short duration bonds. It has returned 9 per cent over the past five years and levies ongoing charges (OCF) of 0.42 per cent.

AXA Global Short Duration Bonds: The fund also targets income as well as capital growth via short duration bonds investment. The proposition, managed by both Nicolas Trindade and Nick Hayes, launched this year so is yet to generate useful comparative data. It has an 0.45 per cent.

Newton Global Dynamic Bond: The fund, managed by Paul Brain, invests in globally diversified portfolio of predominantly higher-yielding corporate and government fixed-interest securities for income and capital growth. It boasts returns of 10.39 per cent over five years and has an OCF of 0.81 per cent.

TwentyFour Monument Bond: The fund aims to provide an attractive level of income relative to prevailing interest rates, while maintaining a strong focus on capital preservation. Its investment policy is to invest in a diversified portfolio of European asset backed securities rated at least BBB- (or equivalent) at the time of investment.

It is managed by Ben Hayward, Rob Ford, Aza Teeuwen, Douglas Charleston, John Lawler and has returned 17.34 per cent over five years. It has an OCF of 0.80 per cent.

M&G Global Floating Rate High Yield: Managed by James Tomlins and Stefan Isaacs, the fund primarily invests in opportunities on more established markets in the US and Europe, though at times he will invest in other regions, such as Asia and Latin America.

Launched in 2014, the fund has returned 11.73 per cent in five years and has an OCF of 0.83 per cent.

Do you want to automatically post your MailOnline comments to your Facebook Timeline?

Your comment will be posted to MailOnline as usual

We will automatically post your comment and a link to the news story to your Facebook timeline at the same time it is posted on MailOnline. To do this we will link your MailOnline account with your Facebook account. We’ll ask you to confirm this for your first post to Facebook.

You can choose on each post whether you would like it to be posted to Facebook. Your details from Facebook will be used to provide you with tailored content, marketing and ads in line with our Privacy Policy.